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Profit of The Cooperating Firms Is Greater Under SA Than Under Full Merger
Profit of The Cooperating Firms Is Greater Under SA Than Under Full Merger
Profit of The Cooperating Firms Is Greater Under SA Than Under Full Merger
\
|
+ =
1
2
2
1
1
0
2
2 9
(2)
while its rival maximizes:
( ) ( )
j
M
j j i
M
M
i
M
j
cK d K K K d
K
d E + |
.
|
\
|
+ =
1
2
2
1
2
1
0
2
2 9
. (3)
It is straightforward to show (proof available by the authors) that the only equilibrium
involves the symmetric capacity choices and profits described in the lemma, QED.
15
Obviously, if c> capacity costs in the AB exceed the maximum expected revenue from that market.
- 7 -
There is no much to comment on the merger case. Each of the merged firms 1,2,
collects half the duopoly profit. Since the two firms act in a fully coordinated manner,
the way they split capacity, hence profits, is irrelevant for the market outcome.
4. The Case of Strategic Alliance
In this section, firms 1 and 2 form a strategic alliance defined as an agreement where
partners a) jointly choose capacity in order to maximize total expected profit, b) share
this capacity equally among themselves,
16
c) market their capacity share independently.
This implies that market structure in the third stage is triopoly, potentially an asymmetric
one. A superscript A indicates equilibrium values in this subgame.
Lemma 2: When airlines 1 and 2 form a strategic alliance, unless c is too small (i.e.,
0006 . 0 > c ),
|
.
|
\
|
+ + = c c c K
A
A
2 5 . 2 2 2 2
4
1
4 1
,
|
.
|
\
|
+ + = c c c K
A
2 5 5 . 2 2 2 2
8
1
4 1
3
,
while =
A
A
( )
+ + +
4 3 2 3
5 2 2 1 2 2 3 1
24
1
c c c c c , and
=
A
3
( )
+ + + + c c c c c c 2 3 5 2 2 1 2 3 2 22 3 1
48
1
4 3 2 3
.
Proof: Since we have assumed a 50% capacity-sharing rule among alliance members,
2
2 1 A
K K K = = . We need to examine two cases according to whether
3
2K K
A
or
3
2K K
A
> . We only present the former since it turns out to be the only equilibrium.
Therefore, as increases, each alliance partner becomes capacity constrained before the
outside firm. Define
A A
K 2
1
= ,
3 2
2K K
A A
+ = , which divide the realizations of into
three zones analogous to those in the merger case. At the first stage, the alliance chooses
its capacity maximizing
17
( ) ( )
A
A
A A
A
A
A
A
A
A
cK d K K K d K
K
d E + |
.
|
\
|
+ =
1
2
3
2
1
1
0
2
2 16
2
(4)
while the outside firm maximizes
16
This division could be viewed as the result of a Nash bargaining outcome where the two airlines have
identical bargaining power.
17
Expressions (4) and (5) are analogous to expressions (2) and (3).
- 8 -
( ) ( )
3
1
2
3 3
2
1
2
1
0
2
3
2 16
cK d K K K d
K
d E
A
A
A
A
A
A
+ |
.
|
\
|
+ =
(5)
Solving the system of first order conditions and substituting optimal capacities into the
profit functions yields the expression in the lemma. Notice that 0006 . 0 c the second
order conditions for the maximization of (5) are not met, which creates a discontinuity in
the reaction function of firm 3. We simply ignore this case since it has no special
interest, QED.
With the two lemmata at hand, we proceed to show
Proposition 1: A strategic alliance is preferable to merger as a means for the
participating firms to collaborate, while the outside firm prefers that its competitors
merge; i.e., ( | 5 . 0 , 0006 . 0 c ,
M
M
A
A
and
M A
3 3
.
Proof: First we compute the
M
M
A
A
difference for all the admissible values of c. The
results are reported in figure 1, which shows that ( | 5 . 0 , 0006 . 0 c ,
M
M
A
A
. Similarly,
figure 2 reports the
M A
3 3
difference, which is positive ( | 5 . 0 , 0006 . 0 c , QED.
The intuition behind the results in proposition 1 is straightforward. Merging
makes the last stage reaction of the joining partners softer, thus yielding market shares to
the outside firm. To see this clearly let first
M A
K K =
12
K = , so
1 1 1
= =
A M
, and compare
profits in demand states where neither the alliance, nor the merged firm is capacity
constrained. From the first integrals in (2) and (4) it is obvious that the alliance performs
better in terms of partners profits. This happens since ] , 0 [
1
capacity choices are
irrelevant and the allied partners behave like unconstrained Cournot triopolists. We find,
therefore, the well know result of Salant, et al. (1893): when firms compete in strategic
substitutes a merger reduces the total profit of the participating firms. Hence, preferring
alliance to merger has a first strategic effect related to third stage outcome and stemming
from low demand states.
Now assume also that whether merger or alliance the outsiders capacity is fixed
at
3 3
K K = . It is easy to show that
( )
( )
( )
( )
( ) 0
2
12
4
1
3
,
12
> =
K
K K
M
K E
M
E
A
K E
A
E
. In other words,
preferring alliance to merger increases the cooperating firms marginal profit due to
- 9 -
capacity and pushes their second stage reaction function outwards. This implies that
M
M
A
A
K K > and
M A
K K
3 3
< . Figure 3 reports the
M
M
A
A
K K difference and shows that it is
positive for all the admissible values of c. This means that the alliances total capacity
exceeds that of the merged firm, therefore, whenever constrained, the alliance partners
have in total a larger market share than their merger counterpart. This holds true
independently of whether the outside firm is capacity constrained. These results also
easily explain why social welfare is always higher under the alliance than the merger (see
Figure 4).
5. Conclusion
We have shown that, in the presence of demand uncertainty airline alliance dominates
merger in terms of profits as a form of cooperation. Strategic alliance is therefore not
necessarily a second best solution justified by regulation limiting airline mergers. In the
model presented here, had the two firms remained independent they would have obtained
higher profits This is due to the fact that, in order to keep matters simple we have ruled
out any cost synergies. Obviously, by allowing for sufficient cost synergies one can find
situations where cooperating yields higher profits than remaining independent. Since the
intuition developed in this paper is unaffected by the presence of such synergies, the
superiority of alliance over merger is robust when the two forms of cooperation provide
similar cost reductions. Obviously, it remains to be verified whether a strategic alliance
allows the same type of cost synergies than a full merger.
18
In terms of policy
implications, our results suggest that, for similar cost savings, SA should be favored over
full merger by the competition authorities.
We have presented the analysis in the framework of a parallel alliance (the
collaborating airlines were supposed to initially operate on AB). Note however that the
18
Note that it is not clear that the merger necessarily performs better in that respect than the SA. Indeed,
suppose that economies of aircraft size are the main source of cost saving associated with cooperation
between airlines (i.e. the per-unit capacity cost is decreasing with the level of capacity). In this case, the
strategic advantage of the SA could very well be reinforced, since the alliance chooses more capacity than
the merged entity, and most important, it creates an asymmetry with the rival. Also, consider, for instance,
that the three airlines are somewhat differentiated, and the uncertainty that they face contains an
idiosyncratic component. If airline 1s idiosyncratic uncertainty is not perfectly correlated with that of firm
2, forming a strategic alliance allows the two airlines to reduce the cost of holding excess capacity, like in
Barla and Constantatos (2000).
- 10 -
same type of strategic effect should favor SA over merger in the case of a complementary
alliance. Indeed, suppose that airline 1 and 2 connect a third city H to cities A and B,
respectively. For some reason (e.g. regulatory constraint), they cannot serve AB directly
but if they collaborate they can offer AB passengers to fly through H. In choosing
whether to merge or to form a SA, the strategic effect identified in our analysis remains
present.
19
We can therefore conclude that, when cooperation is called for by either cost
synergies or regulatory constraints, in the presence of outside rivals SA is profit superior
to merger.
19
Obviously, airlines would also have to consider the impact of their decision on the other markets namely
AH and BH. However, since the SA makes the collaborating airlines more aggressive in terms of capacity
choice, the SA should also be superior to the merger in improving their competitive positions into these
other markets.
- 11 -
References
Barla, P. and C. Constantatos (2000), Airline Network Structure under Demand
Uncertainty. Transportation Research Part E, 36, 173-180.
Barla, P. and C. Constantatos (2005), Strategic Interactions and Airline Network
Morphology under Demand Uncertainty. European Economic Review, vol 49, 3, 703-
716.
Brueckner, J.K. (2001), The Economics of International Codesharing: An Analysis of
Airline Alliances. International Journal of Industrial Organization, vol 19, 10, 1475-
1498.
Chen, Zhiqi and T. W. Ross (2003), Cooperating upstream while competing
downstream: a theory of input joint ventures. International Journal of Industrial
Organization, 21, 381-397.
Flores-Fillol, R. and R. Moner-Collonques (2004) Strategic Effects of International
Airline Alliances Mimeo, Department of Economic Analysis, Universitat de Valncia,
Campus dels Tarongers, 46022-Valcencia, Spain.
Morash, K. (2000) Strategic Alliances as Stackelberg CartelsConcept and Equilibrium
Alliance Structure. International Journal of Industrial Organization, 18, 257-282.
Lin M.H. (2004), Strategic airline alliances and endogenous Stackelberg equilibria.
Transportation Research Part E 40, 357-384.
Lin M.H. (2005), Alliances and entry in a simple airline network. Economic Bulletin,
Vol. 12, No 2, 1-11.
- 12 -
Oum, C., J. H. Park and A. Zhang (2000), Globalization and Strategic Alliances: The
case of the Airline Industry, Pergamon.
Park, J.H. (1997), The Effect of Airline Alliances on Markets and Economic Welfare.
Transportation Research Part E, 33, 181-195.
Salant,S., S. Switzer, and R. Reynolds (1983), Losses Due To Merger: The Effects of an
Exogenous Change in Industry Structure on Cournot-Nash Equilibrium. Quarterly
Journal of Economics 48, 185-200.
Tirole, J. (1989), The Theory of Industrial Organization. MIT Press.
Zhang A. and Y. Zhang (2005), Rivalry between strategic alliances. International
Journal of Industrial Organization, forthcoming.
- 13 -
Figures
0.1 0.2 0.3 0.4 0.5
0.001
0.002
0.003
0.004
Figure 1. The
M
M
A
A
difference for all admissible values of c.
0.1 0.2 0.3 0.4 0.5
-0.015
-0.0125
-0.01
-0.0075
-0.005
-0.0025
Figure 2. The
M A
3 3
difference for all admissible values of c.
Figure 3. The
M
M
A
A
K K difference for all admissible values of c.
- 14 -
Figure 4. Difference (alliance-merger) in total surplus for all admissible values of c.